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Why Is the Market Selling Off Today?

Posted by Larry Doyle on April 20, 2009 2:30 PM |

The broad equity market indices are down 3+% on the day. Why would that happen when the bulk of company news today was generally positive?  At least on the surface the news was positive:

1. Bank of America posted .44 earnings per share vs. expectations of .04
2. Eli Lilly earnings were up 23% outpacing expectations.
3. Halliburton disappointed with earnings down 35% but that is due to the massive correction in the price of oil from a year ago.
Merger Activity:
4. Oracle is purchasing Sun Microsystems in a $7.4 billion deal.
5. Pepsi is buying two bottling companies for $6 billion.
6. Glaxo is purchasing Stiefel for $2.9 billion.

Leading economic indicators declined by .3 but that decline is offset by an improved reading from the prior month.

Then, why is the market down so much? Two reasons are promoted, but only one of them is getting proper coverage.

Market analysts supposedly are focused today on the ongoing increases in chargeoffs and writedowns on the loan portfolios in the banking industry. These loans consist of credit card loans, residential mortgages, commercial mortgages, and corporate loans.

I don’t buy this line of reasoning for today’s selloff. Increased chargeoffs and writedowns have been widely expected for a while. The level of reserves taken by the banks has been widely panned as being insufficient. Then why is the market down so much?

In my opinion, the reason for the market selloff is an underlying concern that Uncle Sam is going to execute a massive equity swap in the banks. What does that mean? Remember, a tremendous amount of government funding that has been injected into the banking system has been in the form of preferred shares in which the taxpayers earn a rate of interest. These preferred shares are senior to common equity (stock) if the bank were to enter bankruptcy. Uncle Sam was protecting the taxpayers’ interest by making sure the money was injected in the form of the preferred and not in the form of common equity.

If the preferred stock is swapped for common stock, Uncle Sam would be taking significantly greater risk on behalf of the taxpayers and the banks would be forced to issue more shares. The increased issuance of shares would dilute the interests of current shareholders. That dilution lowers the value of the current stock and the price of that stock goes DOWN.

Today, most banks are down at least 10% and the major banks are down close to 20%.

While the administration may attempt to utilize this equity swap as a means of increasing the equity capital in the banking system, the taxpayers are taking more risk in the process. Why isn’t this process or proposal debated in Congress so the public is fully aware of the risks involved and can voice their opinions? With Uncle Sam taking a greater equity stake in the banks, the operation of the banks will be under greater scrutiny and compensation levels will be even more closely monitored. Banks lose, taxpayers lose, government control wins.

LD

Representative Darrell Issa (R-CA) just spoke on Bloomberg that banks will likely redirect TARP funds within the banking system (please see my piece earlier today on that very topic). Additionally, he pointed blame at those in Congress and the Fed for promoting unwise and unhealthy lending. He specifically named Barney Frank.

  • Pingback: Why Is the Market Selling Off Today? · Stocks.ExplainedOnline.Net()

  • bonddadddy

    nice close on the day by XLF …………

  • fiscalliberal

    Larry – when TARP bought preferred shares, they gave the banks money. Now they are converting to common. So – how does that improve the banks capital position? In both cases they have the same amount of money.

    This Economic VoDoo needs more expaining.

  • Larry Doyle

    The preferred comes with an explicit rate of interest (coupon) that the banks must pay. The coupon on the government money injected via the TARP is 5%. Compare that to the 10% preferred Goldman issued to Berkshire Hathaway.

    By converting the preferred to common, the banks are not responsible for that 5% payment. Also the common is the bottom rung of the capital structure for the banks. With cheaper capital it improves the banks’ capital ratios that are needed for customers to transact with them.

    You are right, the banks do not technically have more capital but they have cheaper capital which helps the vitally important capital ratios.

    Hope this makes sense.

  • TeakWoodKite

    LD a month and half ago this came up, the cheaper
    source of capital for banks I understand as it is juxtaposed next to the portfolio lossess that occuring.

    What I am curious is how much leverage is gained by
    the Feds(BO Administration) in exchanging the 5 percent?

    If the banks are caught in a “Tarp pit” wanting to pay back the funds and then The BO gives a way an offset, I don’t get it.
    Do they know what they are doing or is this part of “unwinding” these deals? BO is said to want to grap the the ring and gain market control in ways not seen. There is a keystone cop quality to the execution of this “plan”.

    There is a very thin membrane on the bottom of
    this market.

    • TeakWoodKite

      portfolio lossess that are occuring.

  • Larry Doyle

    TKW….the bank regulators (the Comptroller of the Currency) can easily dictate to the major money center banks that they do not have enough Tier 1 capital. In one very swift and quick move the Treasury can convert the preferred holdings to common equity. Remember, this conversion has already occurred with Citigroup. As a result,for all intents and purposes, Uncle Sam is running Citi.






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